Top 6 States Facing Major Financial Stress

By ALAN FARNHAM

July 19, 2012

A new report by the respected State Budget Crisis Task Force paints a chilling picture of what's ahead for U.S. states, even long after the 2008 recession officially ended.

The pessimistic analysis identifies major threats to fiscal sustainability, including: out-of-control Medicaid spending; reductions in federal state-aid; underfunded state retirement plans; an eroding tax base; and laws that allow states to use gimmicks to hide their fiscal troubles.

The co-chairs of the Task Force—former Fed chairman Paul Volker and former New York State lieutenant governor Richard Ravitch—say state governments are coping with the "unprecedented challenges" in their attempt to keep providing "established levels of service with uncertain and constrained resources." States' ability to continue to meet their obligations to their own employees, to their creditors and to their citizens, says the chairmen, "is threatened."

The report's recommendations include the following:
-Reduce budget gimmickry. States should, for example, replace cash-based budgeting with modified accrual budgets, so that legislators and the public can see how revenues earned in any given fiscal year relate to obligations incurred in the same year.

-Enact forecasts and plans that extend at least four years into the future; encourage independent review of these forecasts.

-Strengthen state 'rainy-day' funds. Examples of successful funds, such as those created by Texas and Virginia, should be copied by other states.

-State pension systems need to account more clearly for the risks they assume and for the potential shortfalls they face. States should create mechanisms to ensure that required contributions are paid.

-The federal government should shore up states' eroding tax bases by making it easier for states to collect taxes on goods and services sold over the Internet.

The report examines in particular the health of six states—California, Illinois, New Jersey, New York, Texas and Virginia—because, say its authors, these account for more than a third of the nation's population and almost 40 cents out of every dollar spent by state and local government.

Here's a sampling of the challenges facing these six staes, which the report says face major threats to their ability to provide basic servies:

MEDICAID SPENDING

1.

Illinois

Medicaid, says the report, is the single biggest spending category in most states' budgets and is growing faster than both the economy and state tax revenues. If trends of the past decade continue, the gap between Medicaid spending and state tax revenue growth will increase by at least $22 billion annually within five years. Illinois, by the end of the current year, will face accumulated unpaid Medicaid bills estimated to total $1.9 billion.

REDUCED FEDERAL AID TO STATES

2.

New York

When the federal government gets around to taking significant steps to reduce its budget deficit, predicts the report, "such action could wreak havoc on the states." Even a 10 percent cut in federal aid would cost states a collective $60 billion, the equivalent of eliminating all states' spending on libraries, parks and recreation. Such a cut would cost New York and California more than $6 billion each, but New York's cut per capita ($316.5) would be highest of any of the six states.

UNDERFUNDED RETIREMENT

3.

California

Under current actuarial assumptions, says the report, state and local government pension funds are underfunded by approximately $1 trillion. Despite that shortfall, California and other states have continued to sweeten pension benefits, some retroactively, on the basis of assumptions that in hindsight were too optimistic. California's unfunded liability, based on the current market value of its fund's assets, is greatest of the six states: $135.8 billion. Illinois is next, at $92.5 billion.

ERODING TAX BASE

4.

Texas

The report calls states' sales tax revenues "volatile and eroding." Reasons include a nationwide shift in consumer spending away from goods toward more lightly-taxed services. An increase in cars' fuel efficiency has reduced revenue from fuel taxes. Texas' situation is complicated by the fact that it has no income tax, and so relies "far more heavily" on the sales taxes than do most states. Sales taxes, says the report, have been diminishing relative to the economy. "A 1 percent change in personal income now produces only about an estimated 0.7-0.8 percent increase in sales tax revenue.

LOCAL GOVERNMENT FISCAL STRESS

5.

Virginia

"Fiscal stress rolls downhill," says the report. Suffering states have tried to pass their troubles down to cities, towns and counties—for example, by cutting aid to primary and secondary education. Such moves, however, result in no net reduction of a state's fiscal stress: The pea is just hidden under a different walnut-shell. While laws in some states prevent local governments from raising property tax rates to offset those housing-bust declines in value, Virginia's towns and cities can raise taxes all they want, and some are doing so. What good is achieved? Says the report: "This kind of compensating mechanism only turns potential stress for local governments into actual stress for property owners."

LAWS & PRACTICES THAT HINDER FISCAL STABILITY

6.

New Jersey

Short-term budget gimmicks, says the report, only serve to destabilize a state's long-term finances. One of the most notorious gimmicks, it says, is capitalizing future revenues to produce a balance in a current year, borrowing cash "not just from the year ahead but from many years into the future." An obvious way to end the practice is to put in place "a multi-year financial and capital plan linked to the annual budgeting process." Multi-year planning has been practiced successfully by many states, says the report, but New Jersey isn't one of them: the state has no such plan in place.